Since the Maastricht Treaty was established in the early 1990s, a scientific discussion about effective fiscal rules has been simmering. In addition, there was, and still is, a lively debate about the lessons that we should learn from the sovereign debt crisis. Despite the fact that most monetary unions of the past century have failed, I believe that a credible and enforceable economic governance framework based on market rules is realistic and will be effective. Experience generated by the analysis of past failures enables us to understand the key requirements of a sound rule-based agenda: Credible (pre)conditions and enforceable rules with safeguards.
However, the European Union’s policymakers are still far from finding the right way out of the crisis towards a long-run sustainable monetary union. But there is a solution – and after implementing the new rules, the Eurozone will no longer be endangered.
In general we have two options. However, neither option works without re-establishing and enhancing the credibility of the existing framework. Option A is a fundamental change of the existing policy framework. This option would insist that member states of the Eurozone abandon a substantial part of their national sovereignty over fiscal policy. This would require immediate and fundamental legal changes on the European and national level. The recent judgment by the constitutional court in Germany – which emphasized the need for national parliamentary oversight of European fiscal policy – has mainly eliminated this option for the near future. Also, the implementation of fundamental changes is long, very complex, and requires broad support of citizens in all euro area member states. As these are lacking, a European state is currently not a realistic option.
Option B is based on an effective rule-based framework aligned with market forces and consistent incentives. This gradual development is far more realistic. It would strengthen the fiscal incentives for sound finances within the current framework. However, this decentralizing option requires an enhancement of the fundamental principles of a monetary union. It, too, requires “more Europe” rather than less. Five elements are crucial components of this option:
1. Each member state has to bear the consequences of its own fiscal policy decisions.
2. Market interest rates have to serve as disciplining mechanism of unsound policies.
3. Pre-emptive and automatic enforcement mechanisms have to support compliance of rules.
4. Mechanisms have to smoothen differentials of growth, inflation, and current account.
5. Ultima ratio punishment options have to handle notoriously unsound countries.
The key philosophy behind this option is that countries bear full responsibility for their own policy actions under a rule-based framework. Consequently, we have to go back to a strict no-bailout clause in Article 125 of the Treaty on the Functioning of the European Union. Additionally, the European Central Bank must go back to its primary objective of price-stability and must abide the prohibition of monetary financing.
The existing rule-based framework is neither complete nor credible. But critics of the second approach should keep this in mind: If you, as a market economist, do not believe in the decentralizing and rule-based option, it’s like saying that we shouldn’t have a referee in a football game because he is less skilled than the players. But referees are key elements of all games. We usually believe that players themselves are good at playing, but worse than impartial referees at watching over the rules. This is as true in football as it is in the case of the Eurozone. Only with a referee can the best players show their real talent. Figuratively speaking, referees and good rules prevent countries from playing rough and unfair by supporting fair-play for the best, i.e. most competitive countries.
Read more in this column Bodo Herzog: The False Appeal of Central Banks